Are Royalties Too High in High-Tech? Recent Study Says "No"

Over the past few years, a lot of attention has been paid to the level of royalties that are charged by holders of IP rights, especially when patents are essential to an industry standard. The FTC and the DoJ have been especially active trying to control IP costs among various standardized industries.

Recently, Damien Geradin, professor of Competition Law and Economics at Tilburg University, published a paper titled "What's Wrong With Royalties In High Technology Industries?" to see if something is indeed "askew" with high-tech royalties. At the outset, Geradin reviews 4 hypothetical scenarios to see how differently situated patent holders and market participants are positioned to potentially exploit their holdings:

(1) The essential IP is held by 5 vertically-integrated (VI) firms: in the typical case, the 5 VI firms will cross-license, and no royalty will be exchanged, and the 5 firms compete on the downstream market for the relevant product. Alternately, the firms may charge a royalty and pass the royalty cost down to downstream consumers.

(2) The essential IP is held by 5 VI firms and 5 pure manufacturers need a license to compete downstream: Here, the 5 VI firms will typically grant cross-licenses to each other, but the manufacturers would face a cumulative royalty burden.

(3) The essential IP is held by four vertically-integrated firms plus one pure upstream firm and five pure manufacturers need a license to compete downstream: Since the upstream firm will typically be unwilling to agree on a royalty-free cross license (since the IP will be the upstream firm's main source of revenue), each of the VI firms would face a smaller cumulative royalty burden to the upstream firm, while the manufacturers would face a cumulative royalty to the VI and upstream firms.

(4) The essential IP is held entirely by a pure upstream firm and four vertically-integrated firms and five pure manufacturers need a license to compete downstream: Since the upstream firm holds all the IP, the VI firms and the manufacturers would all be in the same boat.

Geradin analyzes each of these scenarios, and concludes that concerns over IP costs on high-tech standard are overblown - "these concerns often reflect a number of misconceptions and a fair amount of misinformation when it comes to evaluating the royalties that are paid by standard implementers." Geradin concludes:

First, there is a great deal of confusion between the minimum cumulative royalty rate, the maximum cumulative royalty rate and the average cumulative royalty rate that apply to the implementation of a standard. While scholars, policy-makers and industry officials have referred to royalty rates as high as 30% in some sectors, they usually fail to mention that those cumulative rates are not common, but instead apply to implementers that have not technologically contributed to the creation of the standard. Those with essential IP tend pay much lower rates and in some cases do not pay any royalty at all. As we have seen above, it is not illegitimate in itself that firms which did not engage in relevant R&D pay two-digit royalty figures to be entitled to implement the technologies developed by others. Risk should, after all, have its rewards. Thus, relying on the highest cumulative royalty rates (e.g., 30%) paid only by a limited number of industry players to argue that royalty rates are generally too high and that reforms are needed to lower them cannot be taken seriously.

Second, there is no automatic connection between the level of cumulative royalty rates and the prices paid by end consumers. This is because the downstream producers’ ability to pass on such rates depends on a number of market factors, as indicated above. More generally, unless cumulative royalties were extremely high, the prices paid by end consumers are much more likely to be influenced by the degree of downstream competition. Thus, high average cumulative royalty rates may simply arise from the fact there are many players on both upstream and downstream markets, and thus a great deal of competition in the market for the relevant product. As end consumer prices must be the focus on competition authorities, one goal should be to ensure that (efficient) pure manufacturers are not excluded from the downstream market.

Third, pure upstream firms and vertically-integrated firms do not have similar incentives. While vertically-integrated firms compete downstream and can thus have incentives to restrict competition at that level, pure upstream firms have no incentives to reduce downstream competition. Quite the contrary, since royalty rates are their main or only source of revenues, their focus is on increasing downstream output and thereby maximizing royalty payments. Upstream firms not only are lacking incentives to discriminate, but on the contrary may adopt strategies designed to encourage or facilitate entry on the relevant downstream market (for instance, by providing technological support and other forms of relevant assistance to new entrants).

Finally, the reforms that have been proposed to modify the FRAND regime should be based on accurate information and should be evaluated to determine that they will not cause problems that are worse than the alleged diseases they offer to treat. Along these lines, competition authorities should refrain from regulating royalties, a complex task these authorities are not well placed to undertake. Instead, their focus should be to protect and promote downstream competition.

Read/download the paper here.

ISO Pushing Forward to Establish International Standard for Patent Valuation

In an ambitious effort, the International Organization for Standardization (ISO) is moving forward to establish an international standard for patent valuation. According to an email letter from the project’s leader Alexander Wurzer (received yesterday at the IAM blog), the ISO is seeking participants to help in this project

The International Organization for Standardization, ISO, has published a new work item proposal for the standardization of patent valuation processes.

The proposal was initiated by the German Institute for Standardization, DIN, and is based on a publicly available specification PAS 1070 “General Principles of Proper Patent Valuation" (SAB1), published in 2007.

The PAS 1070 was developed by a working committee of DIN, chaired by Prof. Alexander Wurzer, together with representatives from all relevant and concerned groups, including industry, consulting, accounting and academia. The PAS defines general principles and requirements for a reliable and appropriate valuation of patents. Its main intention is to serve as a guideline for users of patent value information, to enable a quality assessment of valuation reports and expert appraisals.

The publication of PAS 1070 encouraged great response, emphasizing the necessity and demand for consolidation and standardization of patent valuation, and for a definition of general principles for proper and reliable patent valuation. It also highlighted that national initiatives in this issue of high global importance are not sufficient.

DIN therefore formed a working committee and initiated this international standardization project on patent valuation at ISO. This shall meet the requirement for an international standard. ISO followed that initiative and will appoint a committee to develop an ISO-standard for patent valuation if all relevant and concerned groups articulate their interest to ISO through their national standardization bodies.

You can participate in the development of an ISO standard on patent valuation.

ISO follows a general procedure in implementing working committees for new work item proposals. Therefore you only have to contact your national standardization body and inform them about this proposal and your interest to join the development of an ISO standard on patent valuation. Your national standardization body as your representative at ISO will follow this proposal and bring all other interested groups in your country together to join the implementation of this ISO standard.

To make such an international project work, individual experts or single companies cannot directly contact ISO, which is why you have to contact your national standardization body. To contact your national standardization body, you may use the following list at ISO which provides direct links to your representatives: http://www.iso.org/iso/about/iso_members.htm

Your national standardization body will fill out the ballot form for the implementation of the ISO committee for this new work item proposal. Your national standardization body can download the required ballot form from the ISO website at www.iso.org/forms by simply following the link: “Form 04 New Work Item Proposal”.

Of course you can further support the development of this ISO standard on patent valuation by forwarding this message to any of your partners who may be interested in or concerned by it. Additional information on ISO standards and procedures can be obtained from http://www.iso.org/ or your national standardization body.

Best regards,

Alexander J. Wurzer

Chairman of the working committee for Patent Valuation at DIN e.V.

For a preliminary run-down of patent valuations techniques, see Grünewald & Wurzer, "Approaches and Methods of Patent Valuation" (link).

See also IAM Magazine, ""Developing a patent valuation standard", May 01, 2007 (link). From the article:

So, how can technical progress be promoted? We need inventions and their exploitation – their realisation or transfer into our daily lives. What helps to facilitate this? Legal protection and money. But surely, there is a lot more we could do; for example, a technology transfer market. For such a market, you need prices. And in order to attract money – which for the main part is risk-averse – you have to reduce the risk incurred. One way of doing this and to establish trust is to devise a generally accepted standard for quantitative financial patent valuation.

This would also help to reduce many of the problems associated with the limited amount of information generally available for investors in the complicated area of technology and patents. And this is what banks have been asking for before they can feel comfortable in investing in patents or in using them as collateral.

FTC Asserts Antitrust Authority on Patent Licenses in Standardized Technologies

In the Matter of Negotiated Data Solutions LLC (File No. 0510094)

In an unusual move, the Federal Trade Commission decided in a 3-2 ruling that the FTC had the authority to file a complaint against company Negotiated Data Solutions ("N-Data") for allegedly charging "excess" licensing royalties for patents related to Ethernet technology in violation of Section 5 of the FTC Act. N-Data obtained the Ethernet-related patents from National Semiconductor Corp, who previously agreed to let the IEEE incorporate them into its Ethernet Standard in exchange for one-time royalties of $1,000 per license. Now, N-Data is trying to increase the royalty payment. According to the FTC's complaint:

The Complaint in this matter alleges that N-Data reneged on a prior licensing commitment to a standard-setting body and thereby was able to increase the price of an Ethernet technology used by almost every American consumer who owns a computer. Based on the facts developed by staff during the investigation, we find reason to believe that this conduct violated Section 5 of the FTC Act.

The impact of Respondent’s alleged actions, if not stopped, could be enormously harmful to standard-setting. Standard-setting organization participants have long worried about the impact of firms failing to disclose their intellectual property until after industry lock-in. Many standard-setting organizations have begun to develop policies to deal with that problem. But if N-Data’s conduct became the accepted way of doing business, even the most diligent standard-setting organizations would not be able to rely on the good faith assurances of respected companies. The possibility exists that those companies would exit the business, and that their patent portfolios would make their way to others who are less interested in honoring commitments than in exploiting industry lock-in. Congress created the Commission precisely to
challenge just this sort of conduct.

The Commission accepted a proposed consent agreement premised on two separate violations: (1) N-Data’s alleged conduct was an unfair method of competition, and (2) their conduct was also an unfair act or practice. Notably, the FTC did not pursue the action under traditional Sherman Act principles, but under "broader authorities" vested in the Commission. Noted the Commission:

We recognize that some may criticize the Commission for broadly (but appropriately) applying our unfairness authority to stop the conduct alleged in this Complaint. But the cost of ignoring this particularly pernicious problem is too high. Using our statutory authority to its fullest extent is not only consistent with the Commission’s obligations, but also essential to preserving a free and dynamic marketplace.

Read the Statement of the Commission here (link)

Read dissenting statements of Chairman Majoras (link) and Kovacic (link)